The present invention relates to financial control and management, and, more particularly, to a system, a method and a computer program product for managing and controlling the disposition of financial resources.
While many individuals employ techniques of one form or another to try to manage their personal finances, they often fail as a result of their ignorance of the effects of inflation on their financial situation. In particular, inflation has a compounding effect on living costs, a fact that is not widely appreciated, and that has a significant effect on personal financial planning.
The compounding process, which is a mathematical operation based on the laws of multiplication, has been referred to as the eighth wonder of the world. This is a result of its ability to greatly magnify (increase) whatever is being compounded over time.
Despite the best attempts to describe with clarity the power of compounding, it still remains a mystery to many. While most are familiar with how investment return compounds, few have come to understand that living costs as measured by inflation increase at a compound rate. The same mathematical operation that increases investment return--which is compounding--increases living costs. This effect complicates the financial planning process.
TABLE 1 ______________________________________ Compounding Inflation During 1949-1994 B C D Approximate A Inflation Conversion Index Time Year Rates Factor Value of Doubling ______________________________________ 100.00 1949 -2.10 .979 97.90 1950 5.90 1.059 103.68 1951 6.00 1.06 109.90 1952 0.80 1.008 110.78 1953 0.70 1.007 111.56 1954 -0.70 .993 110.78 1955 0.40 1.004 111.22 1956 3.00 1.03 114.56 1957 2.90 1.029 117.88 1958 1.80 1.018 120.00 1959 1.70 1.017 122.04 1960 1.40 1.014 123.75 1961 0.70 1.007 124.62 1962 1.30 1.013 126.24 1963 1.60 1.016 128.26 1964 1.00 1.01 129.54 1965 1.90 1.019 132.00 1966 3.50 1.035 136.62 1967 3.00 1.03 140.72 1968 4.70 1.047 147.33 1969 6.20 1.062 156.46 1970 5.60 1.056 165.22 1971 3.30 1.033 170.67 1972 3.40 1.034 176.47 1973 8.70 1.087 191.82 1974 12.30 1.123 215.41 First Doubling 1975 6.90 1.069 230.27 1976 4.90 1.049 241.55 1977 6.70 1.067 257.73 1978 9.00 1.09 280.93 1979 13.30 1.133 318.29 1980 12.50 1.125 358.08 1981 8.90 1.089 389.95 1982 3.80 1.038 404.77 Second Doubling 1983 3.80 1.038 420.15 1984 3.90 1.039 436.54 1985 3.80 1.038 453.13 1986 1.10 1.011 458.11 1987 4.40 1.044 478.27 1988 4.40 1.044 499.31 1989 4.60 1.046 522.28 1990 6.10 1.061 554.14 1991 3.10 1.031 571.32 1992 2.90 1.029 587.89 1993 2.70 1.027 603.76 1994 2.70 1.027 620.06 TOTAL 188.50 ______________________________________
Table 1 lists the annual rates inflation for the period 1949 through 1994. The year 1949 was chosen as the beginning year in the study, since prior to 1949, excluding the eight year period 1941 through 1948, inflation was basically non-existent in the United States on a continuing basis, and typically occurred only during war-time periods. The eight year period from 1941 through 1948 was excluded, since it contains the five year period 1941 through 1945, representing the years of World War II--an inflationary period--and the three year period following World War II, 1946 through 1948. The three years from 1946 through 1948 can be characterized as a period when pent-up demand, which accumulated during the war years, was unleashed in the form of increased consumer spending--which generated inflation. Thus the eight year period from 1941 through 1948 was atypical regarding the rates of inflation that have been experienced in the United States. As a result, 1949 will be the beginning year for measuring increases in the price level.
Column A of Table 1 lists the years of the time period that is covered by this analysis--1949 through 1994. Column B shows the annual inflation rates for the time period. These rates are the annual rates of inflation as reported by the Department of Labor using the CPI-U (consumer price index reading for all urban consumers). Column C shows conversion factors that were calculated by dividing the annual inflation rate (or deflation rate) for each year in Column B by 100 and then adding the whole number 1 to the result. The formula for calculating the conversion factor is shown in equation ##EQU1##
Changing the annual rates of inflation and deflation into conversion factors is necessary to apply the annual rates--by multiplication--to the CPI-U index value for each year that is shown in Column D. In Table 1, the CPI-U index value for each year is calculated by multiplying the CPI-U index value for the prior year by the conversion factor for the year for which the CPI-U index is being calculated. This is exactly how the price level is increased as measured by the CPI-U. That is, the price level for goods and services increases at a compound rate--by multiplication.
As is illustrated in Table 1, a first doubling took place in the average level of prices in 1974--the index value increased to 215.41--and a second doubling took place in 1982--the index value increased to 404.77 (Column D). The United States is now on its way to a third doubling when using 1949 as the base year for measuring compound increases in the average level of prices. It is important to note at this point that each time the price level doubles, the purchasing power of a dollar diminishes. Using 1949 as the point of reference, at the first doubling a 1949 dollar decreased in purchasing power to $0.50, at the second doubling it decreased to $0.25 and at the third doubling it will decrease to $0.125. It is important to note also that when the annual rates of inflation are added together each year during the period 1949 through 1994, the total is 188.50% (Column B). However the increase in the price level was not 188.50%, but rather 520.06% (comparing the ending 1994 index value of 620.06 to the beginning index value of 100--Column D). This is a result of the compounding process.
It is important to keep in mind that at the time of the first doubling, the index value increased from 100 to 200, at the time of the second doubling the index value increased from 200 to 400, at the time of the third doubling the index value will increase from 400 to 800, and at the time of the fourth doubling the index value will increase from 800 to 1600, and so on. In terms of dollars, what originally cost $1 would increase to $2, then to $4, then to $8, then to $16 and so on.
Table 2 shows the increases that take place in the average level of prices--represented by the index value--at the time of the first four doublings. Although only two doublings in the price level have occurred, when using 1949 as the beginning year, four doublings are shown. Significantly, when the sum of the annual rates of inflation total to 72 in any period, the price level (index value) doubles during that period--because the inflation rates are being applied multiplicatively as conversion factors. The number 72 is calculated by adding the inflation rates in Column B of Table 1. Each time a total of 72 is attained during a period of years in Column B, the index value in Column D doubles during that period. Note that 72 is an estimate for determining the time of each doubling. As a result the inflation rates may total slightly more than 72 before a doubling actually takes takes place in the index value (or price level).
TABLE 2 ______________________________________ Time of Doublings Inflation Total Annual Index Total Adjusted Inflation Number of Value Percentage Dollars Rates Doublings 100 Change $1 ______________________________________ 72 1 200 100% 2 72 2 400 300 4 72 3 800 700 8 72 4 1600 1500 16 ______________________________________ *Accuracy of the number 72 is somewhat diminished by the prescence of deflation.
In summary, the major problem that is affecting the personal financial plans of those residing within the United States has been identified above. It is not the effect or component of inflation that increases by addition. Rather, it is the compounding component of inflation--that is, inflation that increases multiplicatively. Compounding inflation is not only driving up average living costs for goods and services as measured by the CPI-U, it is also driving up the cost of homes and college education. Just as investment returns increase at a compound rate, living costs, home costs and college costs do likewise, each compounding at their own specific rates of inflation.
This presents a serious problem that the typical American does not realize, let alone know how to address. In summary, annual inflation rates for living costs, homes or college do not increase additively--by addition--but multiplicatively--by multiplication. This process of multiplying the index value of the prior year by the inflation rate of the current year expressed as a conversion factor--which is mechanically how the price level increases--sets the compounding process in motion (see Column D of Table 1). Note that the cost of any item also increases in the same manner--that is, the prior year's cost is multiplied by the current year's inflation rate as a conversion factor. This would include the costs of homes, college education, cars and so on.
It is the compounding process that generates a snowballing increase in the price level. At each doubling, or 100% increase, the index value does not increase additively--from 100% to 200%, 200% to 300%, 300% to 400% and so on--but rather multiplicatively--from 100% to 200%, 200% to 400%, 400% to 800%, 800% to 1600% and so on.
FIG. 10 helps to clearly illustrate the need for this invention. As indicated in FIG. 10, between 1950 and 1994 median family incomes have risen from $3,319 to $38,782. However while incomes have been increasing, the value of the dollar has been depreciating--declining in purchasing power. In fact the purchasing power of a 1994 dollar, stated in terms of the purchasing power of a 1950 dollar, has declined to approximately 18 cents (having approximately 1/6 the purchasing power).
Therefore as incomes rise, purchasing power declines. This illustrates the problem of two economic forces moving in opposite directions and at different rates--yet affecting the same medium of exchange--which is the dollar. If inflation did not exist, we could remove from FIG. 10 the declining value of the dollar, as the prices of goods and services would be the same year in and year out. Rising incomes and a declining dollar present a confusing reality. People are earning more but their dollars are worth less. How does one couple together this economic dysfunction of rising incomes and declining purchasing power in order to accurately determine if they are ahead, behind or simply keeping pace with living costs? This invention unwinds and untangles this economic dysfunction of rising incomes coupled with a declining dollar (due to inflation) in order to provide an approach for inflation adjusting family income performance, living costs and savings. Let's take a closer look at the problem.
FIG. 11 illustrates the ranges of 1994 family incomes and is being used to provide a macro perspective of family earnings in the United States. As illustrated, in 1994 9% of all family incomes were under $10,000, 22% were between $10,000 and $24,999, 32% were between $25,000 and $49,999, 20% were between $50,000 and $74,999 and 17% were over $75,000. From here we will move to the FIG. 12 which illustrates median family incomes from 1950 to 1994 for selected time periods. (Note the term median denotes midpoint which is different from the average and family is defined as two or more persons residing together related by marriage, adoption or birth).
As illustrated in FIG. 12, in 1950 median family income in the United States was $3,319. By 1994 that figure increased to $38,782--an increase of 11.7 times. However while earnings were increasing, the purchasing power of the dollar was simultaneously decreasing--this being a result of inflation increasing living costs. In other words families were earning more but their dollars were buying less--an economic dysfunction.
According to the Consumer Price Index X1 (CPI-U X1), an accepted government index for restating current dollars to constant dollars (which differs from the CPI-U), from 1950 to 1994 the price level increased 5.66 times or 466%. Therefore what cost on average $1 in 1950 increased to approximately $5.66 in 1994. Stated another way, a 1994 dollar in terms of a 1950 dollar had about one sixth the purchasing power. Therefore when comparing the 1950 median family income figure of $3,319 to the 1994 figure of $38,782, one must first adjust for the fact that inflation is driving down the dollar's purchasing power. To accurately compare the numbers across time, either the figures in the chart must be restated in terms of the purchasing power of a 1994 dollar or the figures must be restated in terms of the purchasing power of a 1950 dollar.
Restating the 1994 figure of $38,782 in terms of a 1950 dollar's purchasing power yields $6,852 ($38,782 divided by 5.66, 5.66 representing the increase in the price level from 1950-1994). Comparing the inflation adjusted income figure of $6,852 to $3,319 yields an increase--after accounting for inflation--of approximately 106% during the period 1950-1994. Approaching the situation from the current level of prices (the 1994 price level), and restating the figures in FIG. 12 to the current level of prices (stated in terms of the purchasing power of a 1994 dollar) produces FIG. 13.
FIG. 13 begins with 1950 median family income of $18,774. Keep in mind all the figures in the chart have been restated to the current level of prices. Therefore the $18,774 median family income figure represents the amount of income needed in 1994 to buy the same amount of goods and services that $3,319 purchased in 1950 (1950 median family income of $3,319 multiplied by 5.66, the increase in the price level from 1950-1994 as measured by the CPI-U X1--the accepted government index for restating current dollars to constant dollars--in this example 1994 dollars). The other figures in FIG. 13, except the most recent figure which is 1994 , are also inflation adjusted in the same manner--by taking the non inflation adjusted numbers in FIG. 12 and then increasing them by the rise in the price level--as reported by the CPI-U X1-using the comparative percentage change between each year in the chart and the year 1994 as the multiplier.
Once the figures are restated in 1994 dollars--the most recent year in FIG. 13--termed constant dollars--we can now accurately and correctly compare the numbers. As illustrated during the first 20 year period 1950-1970--median family incomes increased from $18,774 to $35,407, an increase of 89% after accounting for inflation--termed a real increase. During the next 24 year period incomes increased from $35,407 in 1970 to $38,782 in 1994, an increase of 10%. Therefore it is clear in FIG. 13 that during the first 20 years of the period 1950-1994, median family incomes increased significantly-almost doubled.
However during the next 24 year period, income performance began to slow considerably only increasing 10% over a 24 year period on an inflation adjusted basis. For the overall period 1950-1994 the increase is 106%, from $18,774 in 1950 to $38,782 in 1994. FIG. 13 is informing us that incomes have been increasing during both periods, however during the latter the increases in inflation were almost commensurate with that of family incomes. As a result families were unable to provide for improvements in their their standard of living, an increase in their savings rate or both.
It must be pointed out that inflation picked up during the last 24 years in FIG. 13, accelerating the decline in the purchasing power of the dollar (refer to FIG. 10--see decline in dollar's purchasing power). Further it is important to keep in mind that during the first 20 year period there was predominantly one wage earner while during the second period their has been an increase to two wage earners. As a result their is a definite need to understand inflation better, and to devise a method to measure its effects as it relates to personal financial planning. This has led to the development of this invention.